BlogCanada should look to &#8216;economic complexity&#8217; to drive sustainable growth

Canada should look to ‘economic complexity’ to drive sustainable growth

September 27, 2016

In the wake of slow growth in the global economy, the federal government has appointed the Advisory Council on Economic Growth in March to help formulate a strategy for the Canadian economy. In addition to the primary focus areas it has currently outlined, the Council should look to another critical factor that could determine Canada’s long-term economic potential – economic complexity.

Complexity could unlock growth potential

Research led by Ricardo Hausmann (Harvard Kennedy School) and Cesar A. Hidalgo (MIT) provides convincing evidence that the variation in living standards and economic development across countries can be explained by a country’s productive knowledge base or economic complexity. The theory behind economic complexity suggests that every country produces a number of goods, which implicitly reflects the productive capacity that it has developed over time. For any given country, the authors use trade statistics to identify economic complexity through:

a) Diversity: the number of unique products it exports with revealed comparative advantage (a country’s exports of that product as a share of total exports are higher than global exports of that product as share of total global trade)

b) Ubiquity: the number of other countries that export these goods (fewer countries translates to lower ubiquity)

The idea is that countries that produce a larger variety of products are able to do so because they have a broader knowledge base and hence have greater economic complexity. Moreover, economies are also more complex if they export goods that only a handful of other countries are able to produce, since they likely require a substantial accumulation of knowledge to create.

To ensure that these factors are a good indication of economic complexity, they are considered iteratively and used to correct one another. Not all ubiquitous products are necessarily complex. Natural resource exports, for example, may be rare, but if other countries that export them are not diverse then their scarcity is not a reflection of complexity. In the same way, a diverse economy is not truly complex if it exports a large range of products that are commonly exported by many other countries.

Economic Complexity Index (ECI) scores were found to be a strong predictor of both the level and growth rate of GDP per capita. In particular, the ECI scores were much better at explaining variations in growth rates than prevalent measures of governance, human capital, and competitiveness.

GDP per capita versus Economic Complexity Index

How does Canada perform?

The Observatory of Economic Complexity provides a visualization tool for economic complexity across the globe. According to their ECI, Canada ranks 23rd out of 185 countries studied and exports 248 products with comparative advantage. Canada’s economic complexity can be better understood by examining its exports on the product space.

Canada’s economic complexity on the product space

The product space is a visualization of all goods produced in the world and their connections to one another are based on the likelihood that a country exports them simultaneously. The position of each product relative to others reflects the ability for a country to be able to move from one capability to another—it is difficult for an economy to transition towards isolated goods far removed from its current productive structure. The highlighted nodes represent the goods that a country exports with comparative advantage. Each node represents a unique product and is coloured according to groupings. The bright red nodes, for example, are all wood products.

Sweden, despite exporting a fraction of what Canada exports ($160B versus $448B), ranks 4th in economic complexity. Sweden’s economic structure in the product space reveals that it exports a greater number of products with revealed comparative advantage (332). Of these goods, many are machines (blue nodes) that can only be exported by a small number of diverse, industrial economies with a sizable knowledge base. Both the great diversity and lower ubiquity of its products contribute to Sweden’s superior economic complexity ranking.

Sweden’s economic complexity on the product space

Why this matters for Canada

In the early 1980s Canada ranked in the top 10 for most complex economies in the world but since then has experienced a significant decline. Natural resources were a critical determinant for growth in Canada but the slump in natural resource prices makes a strong case for growth led by economic complexity. Using the product space as a road map, economic complexity analysis can help businesses and policy makers better understand Canada’s current productive capacity and identify areas for diversification into more complex goods. For government, it is important to emphasize that they play a vital role in laying the framework to allow the economy to transition beyond its current economic structure.